The FDR Framework is the backbone for a 21st century financial system. Under this framework, governments ensure that every market participant has access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to analyze this data because they are responsible for all gains and losses.

Saturday, July 6, 2013

ECB's Coeure: 'Zombie-banks' pose Japan-like threat

After almost six years of pretending that banks are not insolvent, the ECB executive board member Benoit Coeure tears down the facade and observes that the 'zombie-banks' pose a Japan-like threat to the real economy.

Specifically, Coeure focuses on the economic distortions that are brought about by these banks continuing to lend against and transform non-performing loans to 'zombie-loans'.

Policymakers and financial regulators in the EU, UK and US adopted the Japanese Model for handling a bank solvency led financial crisis at the beginning of the crisis. So it is not at all surprising to see these economies going through Japan's experience.

Under this model, bank book capital levels and banker bonuses are protected at all costs.

The major cost of protecting bank book capital levels is that it transfers the burden of the excess debt onto the real economy. Not only does this divert capital needed for reinvestment, growth and supporting the real economy to debt service, but it creates economic distortions in market competition (aka, pricing).

Regular readers know that there is only one way to end 'zombie banks' and the distortions they create. Adopt the Swedish Model and require the banks to recognize upfront the losses on the excess public and private debt in the financial system.

The Swedish Model puts the burden of the excess debt on the banks where it belongs and frees the real economy to return to normal functioning.

Your humble blogger says the burden of the excess debt belongs on banks because they are designed to absorb the losses on this debt and protect the real economy. Banks can absorb losses because of the combination of deposit insurance and access to central bank funding. With deposit insurance, when banks have low or negative book capital levels, taxpayers effectively become their silent equity partners.

European Central Bank Executive Board member Benoit Coeure warned Friday that the region's "Zombie Banks" could pose a danger to the Eurozone recovery and said lessons needed to be learned from Japan's so-called "lost decade" in order to prevent it from happening here.

In prepared remarks for a speech at an investment conference in Paris, Coeure said banks that are reluctant to call in bad loans for fear of writing off existing capital were a real threat to the region's banking system if left unchecked.

He also noted the regulatory capital requirements could give some banks the "perverse incentive" to extend credit to insolvent borrowers.

"[Zombie bank] are a problem for regulators, because they have an incentive to take excessive risks, for example, by extending loans to ex-ante risky new customers," Coeure said. "A deeper concern, however, is that zombie banks may pose risks for medium to long-term growth if they engage in so-called "evergreening" of loans, which is often discussed with reference to Japan."...

the Japanese government's strategy of guaranteeing the liabilities of struggling lenders "effectively kept wages high and prices low, reducing the profits that new productive firms generated and distorting market competition. As a result, even solvent banks had very few good lending opportunities and the economy remained stagnant throughout the 1990s."...

A major issue for Coeure, however, is the reliance many euro area banks have on the purchase of government debt.

"Banks in countries under stress have, in particular, been investing in relatively risky government bonds, using cheap short-term funding, hoping to pocket the spread between the bond return and the cost of funding on the upside," he said. "This phenomenon shares unsavoury features with the behaviour of banks during Japan's lost decade."...

"This sovereign-bank nexus, whereby domestic banks become the main creditor to national governments, in return increasing the government's incentive to intervene in its banking sector, can become a threat to long-term economic recovery in the euro area.

Unless both bank balance sheets and public finances are sanitised, and the link between the banks and sovereigns is broken, the euro area may indeed have a long recovery ahead of it, with insufficient loan supply to creditworthy enterprises, depressed productivity and high unemployment rates."

About this blog

A blog on all things about Wall Street, global finance and any attempt to regulate it. In short, the future of banking and the global financial system.

This blog will be used to discuss and debate issues not just for specialists, but for anyone who cares about creating good policies in these areas.

At the heart of this blog is the FDR Framework which uses 21st century information technology to combine a philosophy of disclosure with the practice of caveat emptor (buyer beware).

Under the FDR Framework, governments are responsible for ensuring that all market participants have access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to use this data because under caveat emptor they are responsible for all gains and losses on their investments; in short, Trust but Verify.

This blog uses the FDR Framework to explain the cause of the financial crisis and to evaluate financial reforms like the ABS Data Warehouse.